From an article appearing in the CPA Litigation Counselor, entitled,
"Determining Damages Under Insurance Indemnity Contracts-Appropriate Measures,"
Steven J. Meils, CPA, October 1999
Many years ago those drafting the first insurance indemnity contracts recognized the inherent differences in the measurement objectives of the indemnity contract compared to those of financial accounting and reporting. In the world of financial accounting, the accountant concerns him-or herself with the presentation of financial information in a fair, complete and objective manner. However, it is the measurement objective of indemnity accounting to find an amount that would restore an insured to the financial condition that likely would have resulted or been achieved without damage or destruction of property or a resulting suspension of operations. The amount of measured damages recoverable will normally depend on the provisions of the insurance policy.
Over time basic accounting concepts, assumptions, principles, and modifying conventions have emerged and have been adopted by the accounting profession. The body of theory comprising those principles provides the foundation for what is commonly referred to as Generally Accepted Accounting Principles (GAAP).
In many cases the principles relevant in financial accounting will be equally relevant in insurance indemnity accounting. For example, when one uses the historical trends in monthly sales to project likely sales during a period of indemnity, it is important that the historical sales used for projections be reported in the periods actually earned. If this is not the case a sales projection may result that is not indicative of the sales that likely would have occurred during the period of indemnity.
Similarly, historical operating expenses must be reported in the periods in which they were incurred if they are to be relied upon for expense projections and to determine the appropriate values in loss calculations. Thus the revenue realization principle, a basic principle in financial accounting, is equally important in insurance indemnity accounting.
Actual Cash Value and Gross Earnings
It is not necessary to look any further than the basic accounting principles to determine that certain concepts which are a part of the body of financial accounting are not relevant in insurance indemnity accounting. They are not relevant because they do not lead us to the appropriate measure of damages.
It is for this reason that concepts such as actual cash value, and gross earnings, or alternatively, net income and all operating expenses emerged in the insurance indemnity contract. Although the concepts are seldom discussed in the accounting profession literature and have no meaning in financial accounting, they have a very definite meaning and purpose in indemnity accounting: Both concepts represent the potential loss exposures (values) the insured and insurer may face in the event of property damage and resulting business income losses.
Actual Cash Value and Historical Cost
Property valuation and the valuation of all other assets in financial accounting normally are based on historical cost. The financial accountant uses historical cost because it provides a definite and determinable value. No speculation or opinions are required with regard to property valuation in financial accounting.
When measuring the financial damage that would result from the damage or destruction of property under the indemnity contract, however, the recovery of historical cost reduced for accumulated depreciation would not always indemnify an insured for the economic harm that may have resulted from the loss of property, unless the equipment had been recently acquired.
With the passage of time the difference between the book values of property and the related actual cash values (replacement costs with appropriate adjustment for economic depreciation) will normally increase.
In most cases, the use of historical cost in connection with property valuation under the indemnity contract would provide less than the indemnity intended by the contract. Thus, the concept of “actual cash value” is required to provide a basis for valuation that will achieve the objectives of the contract. That objective is to find the amount that would restore an insured to its pre-loss condition.
From a practical standpoint, to find that amount we would normally first determine the amount it would cost to replace the damaged or destroyed property with property of a like kind and quality. If an insured were allowed to recover on this basis for its property however, clearly it would have improved its position as a result of the loss incident in that it would now have a new item of property without wear and tear that is probably functionally improved over the property destroyed.
In order to place an insured in its pre-loss position then, amounts representing the economic depreciation due to wear and tear or obsolescence for property damaged or destroyed must be calculated and deducted from replacement costs. After doing so, presumably the insured is made whole for its economic loss without betterment.
The Matching Principle
The matching principle, dictates that expenses be matched with revenues when realized. Costs normally are classified as product costs or period costs. Material, labor, and overheads are product costs attaching to the product and charged against revenues/sales when earned.
Period costs such as officers’ salaries or other general and administrative costs and selling expenses normally are charged off immediately because there is no direct relationship between the costs and sales. The cost of sales in financial accounting for a manufacturer normally includes labor and other items of overhead expense that may and often do continue in the event of a business suspension.
When calculating the business income loss values for manufacturers, the income statement must be rearranged to reflect all labor and overheads other than manufacturing supplies and freight as operating expenses. The coverage definition in the standard business income contract provides that the applicable loss is based on the sum of net income (net profit or loss before income taxes) that would have been earned or incurred and continuing normal operating expenses, including payroll.
If certain items characterized as product costs in financial accounting were not reclassified as operating expenses, an insured would not be fully indemnified for its losses when the coverage definition is applied. In addition, certain items normally characterized as general and administrative or selling expenses in financial accountings, e.g., bad debts or collection expenses, should be reflected in loss calculations as adjustments to sales. Those items would not continue without sales.
The Replacement Costs of Manufactured Inventories
In practice, the valuation of damaged or destroyed inventories under the property insurance contract often is controversial under replacement cost or actual cash value coverages. This is because the concept of full absorption accounting is ingrained in most accountants as a part of their formal education and training.
It is often difficult for the accountant to remove him- or herself from the realm of financial accounting and related measurement objectives. The economic harm that may result from the destruction of inventories may not include the cost of fixed overheads allocated to inventories.
To the extent that they continue during a period of suspension, fixed overheads are business income loss exposures and the appropriate coverages should be obtained to cover those expenses. In most cases, those overhead costs would be incurred with or without a loss incident and would not increase the insured’s direct out-of-pocket costs to replace the inventories.
In addition, the replacement costs of replacement inventories incurred after the period of suspension also should not include fixed manufacturing overhead. However, greater than normal variable production costs incurred to replace inventories are permissible in a claim for replacement costs of inventories or may be covered under expense to reduce loss or extra expense coverages.
How the Courts have viewed the Indemnity Measurement Objective
With regard to the determination of actual cash values, the courts have generally followed one of three approaches:
1. replacement cost less depreciation;
2. market value; or
3. the broad evidence rule.
Replacement Cost less Depreciation
Simply stated, this method reduces a determined replacement cost value for depreciation caused by use, wear and tear, or obsolescence. The calculated depreciation should reflect the actual economic depreciation as opposed to statutory tax concepts of depreciation.
Market Value
Market value generally is regarded as the amount an item of property is worth between a willing buyer and a willing seller. Depreciation and obsolescence normally would be a consideration for the buyer and seller in the determination of market value.
The Broad Evidence Rule
The broad evidence rule, established in McArnarney v. Newark Fire Insurance Co., 247 N.J. 176, 159 N.E.902, allows the trier of facts to consider any evidence logically tending to the formation of a correct estimate of the value of insured property at the time of loss. The rule provides flexibility in the determination of values. The rule is now employed by courts in almost half of the United States.
In its adoption of the broad evidence rule in Travelers Indemnity v. Orrie L. Armstrong, 442 N.E. 2d 349, the Indiana Supreme Court makes clear the objective of the indemnity contract. In its opinion it states, "The actual cash value policy is a pure indemnity contract. Its purpose is to make the insured whole but never to benefit him because a fire occurred," citing Appleman on Insurance, 2d S 3823 at pp. 218-219.
In Elberon Bathing v. Ambassador Insurance 77 N.J. 1, 389 A.2d 439, (1978), the court states, "McAnarney was intended to insure application of the principle of indemnity," i.e., to make the measure of recovery for fire insurance losses correspond to the actual pecuniary loss sustained by the insured. The court also states that "under-valuation denies the insured the indemnification due him under the policy. Over-valuation tempts the insured to cause the very loss covered, or at least, to provide inadequate safeguards against the loss."
With regard to the measurement objective of the business interruption/income contracts, the objective identified in Northwestern States Portland Cement Co. v Hartford E.I. Co., 360 F. 2d 531 (8th Circuit, 1966), is not uncommon. In this case the court stated,
"The purpose of business interruption insurance is to protect the insured against loss that occurs when its operations are unexpectedly interrupted, and to place it in the position it would have occupied if the interruption had not occurred." The court further stated, "A related rule is that a policy of this type may not be used to place the insured in a better position than it would have occupied in the absence of the catastrophe," citing Supermarkets Operating Co. v. Arkwright Mutual Insurance Co., 257 F. Supp 273.
Conclusion
As previously discussed, the use of GAAP may provide a result that falls short of the indemnity objective intended by the contract and acknowledged in various courts.
Because the CPA frequently is called on to measure damages under the indemnity contract and to testify in proceedings when amounts of loss are in dispute, it is important that he or she be familiar with insurance indemnity concepts and the related measurement objectives.
When seeking to measure a financial loss, principles and practices may be required that are not part of the body of GAAP. Those who are engaged in such assignments must understand when the use of GAAP is appropriate and when it is not.
"Determining Damages Under Insurance Indemnity Contracts-Appropriate Measures,"
Steven J. Meils, CPA, October 1999
Many years ago those drafting the first insurance indemnity contracts recognized the inherent differences in the measurement objectives of the indemnity contract compared to those of financial accounting and reporting. In the world of financial accounting, the accountant concerns him-or herself with the presentation of financial information in a fair, complete and objective manner. However, it is the measurement objective of indemnity accounting to find an amount that would restore an insured to the financial condition that likely would have resulted or been achieved without damage or destruction of property or a resulting suspension of operations. The amount of measured damages recoverable will normally depend on the provisions of the insurance policy.
Over time basic accounting concepts, assumptions, principles, and modifying conventions have emerged and have been adopted by the accounting profession. The body of theory comprising those principles provides the foundation for what is commonly referred to as Generally Accepted Accounting Principles (GAAP).
In many cases the principles relevant in financial accounting will be equally relevant in insurance indemnity accounting. For example, when one uses the historical trends in monthly sales to project likely sales during a period of indemnity, it is important that the historical sales used for projections be reported in the periods actually earned. If this is not the case a sales projection may result that is not indicative of the sales that likely would have occurred during the period of indemnity.
Similarly, historical operating expenses must be reported in the periods in which they were incurred if they are to be relied upon for expense projections and to determine the appropriate values in loss calculations. Thus the revenue realization principle, a basic principle in financial accounting, is equally important in insurance indemnity accounting.
Actual Cash Value and Gross Earnings
It is not necessary to look any further than the basic accounting principles to determine that certain concepts which are a part of the body of financial accounting are not relevant in insurance indemnity accounting. They are not relevant because they do not lead us to the appropriate measure of damages.
It is for this reason that concepts such as actual cash value, and gross earnings, or alternatively, net income and all operating expenses emerged in the insurance indemnity contract. Although the concepts are seldom discussed in the accounting profession literature and have no meaning in financial accounting, they have a very definite meaning and purpose in indemnity accounting: Both concepts represent the potential loss exposures (values) the insured and insurer may face in the event of property damage and resulting business income losses.
Actual Cash Value and Historical Cost
Property valuation and the valuation of all other assets in financial accounting normally are based on historical cost. The financial accountant uses historical cost because it provides a definite and determinable value. No speculation or opinions are required with regard to property valuation in financial accounting.
When measuring the financial damage that would result from the damage or destruction of property under the indemnity contract, however, the recovery of historical cost reduced for accumulated depreciation would not always indemnify an insured for the economic harm that may have resulted from the loss of property, unless the equipment had been recently acquired.
With the passage of time the difference between the book values of property and the related actual cash values (replacement costs with appropriate adjustment for economic depreciation) will normally increase.
In most cases, the use of historical cost in connection with property valuation under the indemnity contract would provide less than the indemnity intended by the contract. Thus, the concept of “actual cash value” is required to provide a basis for valuation that will achieve the objectives of the contract. That objective is to find the amount that would restore an insured to its pre-loss condition.
From a practical standpoint, to find that amount we would normally first determine the amount it would cost to replace the damaged or destroyed property with property of a like kind and quality. If an insured were allowed to recover on this basis for its property however, clearly it would have improved its position as a result of the loss incident in that it would now have a new item of property without wear and tear that is probably functionally improved over the property destroyed.
In order to place an insured in its pre-loss position then, amounts representing the economic depreciation due to wear and tear or obsolescence for property damaged or destroyed must be calculated and deducted from replacement costs. After doing so, presumably the insured is made whole for its economic loss without betterment.
The Matching Principle
The matching principle, dictates that expenses be matched with revenues when realized. Costs normally are classified as product costs or period costs. Material, labor, and overheads are product costs attaching to the product and charged against revenues/sales when earned.
Period costs such as officers’ salaries or other general and administrative costs and selling expenses normally are charged off immediately because there is no direct relationship between the costs and sales. The cost of sales in financial accounting for a manufacturer normally includes labor and other items of overhead expense that may and often do continue in the event of a business suspension.
When calculating the business income loss values for manufacturers, the income statement must be rearranged to reflect all labor and overheads other than manufacturing supplies and freight as operating expenses. The coverage definition in the standard business income contract provides that the applicable loss is based on the sum of net income (net profit or loss before income taxes) that would have been earned or incurred and continuing normal operating expenses, including payroll.
If certain items characterized as product costs in financial accounting were not reclassified as operating expenses, an insured would not be fully indemnified for its losses when the coverage definition is applied. In addition, certain items normally characterized as general and administrative or selling expenses in financial accountings, e.g., bad debts or collection expenses, should be reflected in loss calculations as adjustments to sales. Those items would not continue without sales.
The Replacement Costs of Manufactured Inventories
In practice, the valuation of damaged or destroyed inventories under the property insurance contract often is controversial under replacement cost or actual cash value coverages. This is because the concept of full absorption accounting is ingrained in most accountants as a part of their formal education and training.
It is often difficult for the accountant to remove him- or herself from the realm of financial accounting and related measurement objectives. The economic harm that may result from the destruction of inventories may not include the cost of fixed overheads allocated to inventories.
To the extent that they continue during a period of suspension, fixed overheads are business income loss exposures and the appropriate coverages should be obtained to cover those expenses. In most cases, those overhead costs would be incurred with or without a loss incident and would not increase the insured’s direct out-of-pocket costs to replace the inventories.
In addition, the replacement costs of replacement inventories incurred after the period of suspension also should not include fixed manufacturing overhead. However, greater than normal variable production costs incurred to replace inventories are permissible in a claim for replacement costs of inventories or may be covered under expense to reduce loss or extra expense coverages.
How the Courts have viewed the Indemnity Measurement Objective
With regard to the determination of actual cash values, the courts have generally followed one of three approaches:
1. replacement cost less depreciation;
2. market value; or
3. the broad evidence rule.
Replacement Cost less Depreciation
Simply stated, this method reduces a determined replacement cost value for depreciation caused by use, wear and tear, or obsolescence. The calculated depreciation should reflect the actual economic depreciation as opposed to statutory tax concepts of depreciation.
Market Value
Market value generally is regarded as the amount an item of property is worth between a willing buyer and a willing seller. Depreciation and obsolescence normally would be a consideration for the buyer and seller in the determination of market value.
The Broad Evidence Rule
The broad evidence rule, established in McArnarney v. Newark Fire Insurance Co., 247 N.J. 176, 159 N.E.902, allows the trier of facts to consider any evidence logically tending to the formation of a correct estimate of the value of insured property at the time of loss. The rule provides flexibility in the determination of values. The rule is now employed by courts in almost half of the United States.
In its adoption of the broad evidence rule in Travelers Indemnity v. Orrie L. Armstrong, 442 N.E. 2d 349, the Indiana Supreme Court makes clear the objective of the indemnity contract. In its opinion it states, "The actual cash value policy is a pure indemnity contract. Its purpose is to make the insured whole but never to benefit him because a fire occurred," citing Appleman on Insurance, 2d S 3823 at pp. 218-219.
In Elberon Bathing v. Ambassador Insurance 77 N.J. 1, 389 A.2d 439, (1978), the court states, "McAnarney was intended to insure application of the principle of indemnity," i.e., to make the measure of recovery for fire insurance losses correspond to the actual pecuniary loss sustained by the insured. The court also states that "under-valuation denies the insured the indemnification due him under the policy. Over-valuation tempts the insured to cause the very loss covered, or at least, to provide inadequate safeguards against the loss."
With regard to the measurement objective of the business interruption/income contracts, the objective identified in Northwestern States Portland Cement Co. v Hartford E.I. Co., 360 F. 2d 531 (8th Circuit, 1966), is not uncommon. In this case the court stated,
"The purpose of business interruption insurance is to protect the insured against loss that occurs when its operations are unexpectedly interrupted, and to place it in the position it would have occupied if the interruption had not occurred." The court further stated, "A related rule is that a policy of this type may not be used to place the insured in a better position than it would have occupied in the absence of the catastrophe," citing Supermarkets Operating Co. v. Arkwright Mutual Insurance Co., 257 F. Supp 273.
Conclusion
As previously discussed, the use of GAAP may provide a result that falls short of the indemnity objective intended by the contract and acknowledged in various courts.
Because the CPA frequently is called on to measure damages under the indemnity contract and to testify in proceedings when amounts of loss are in dispute, it is important that he or she be familiar with insurance indemnity concepts and the related measurement objectives.
When seeking to measure a financial loss, principles and practices may be required that are not part of the body of GAAP. Those who are engaged in such assignments must understand when the use of GAAP is appropriate and when it is not.
